The Great Moderation is a term that describes a significant period of reduced macroeconomic volatility in the United States beginning in the mid-1980s and lasting until the financial crisis of 2007. During this time, the country experienced a remarkable decrease in the fluctuations of key economic indicators, notably the standard deviation of quarterly real Gross Domestic Product (GDP) decreased by nearly 50%, while inflation's variability diminished by two-thirds. This shift allowed for a multi-decade environment characterized by prolonged low inflation rates and consistently positive economic growth.
The Timeline of the Great Moderation
Economic Distress of the Previous Decades
A close examination of the Great Moderation reveals contrasts against a backdrop of severe economic upheaval. The years leading to this period were marked by extreme economic volatility: - In the 1960s, inflation soared due to the costs associated with the Vietnam War. - The 1970s witnessed the collapse of the Bretton Woods system, leading to stagflation — a combination of stagnation and inflation that perplexed economists. - The early 1980s were characterized by tumultuous fluctuations in interest rates and inflation, culminating in deep recessions.
These pronounced economic cycles set the stage for the relative calm of the Great Moderation.
Emergence of the Great Moderation
The Great Moderation began to unfold in the mid-1980s. Inflation stabilized, and the economy expanded without the sharp fluctuations that had characterized the prior decades. As the country transitioned into this new era, unemployment rates decreased, and consumer confidence strengthened. Recessions during this period appeared less severe, occurring less frequently and lasting for shorter durations compared to previous economic contractions.
Causes of the Great Moderation
In a 2004 speech, former U.S. Federal Reserve Chair Ben Bernanke proposed three key factors contributing to the emergence of the Great Moderation:
-
Structural Changes in the Economy: Increased utilization of technology, especially computers, transformed business operations, enabling more informed decision-making. The economy transitioned towards a service-oriented model, and financial systems underwent significant deregulation, facilitating growth.
-
Improved Economic Policies: With advancements in the understanding of monetary and fiscal policy, policymakers became more adept at managing economic fluctuations. Interest rates were often adjusted more responsively to combat inflation and stimulate growth.
-
Good Luck: Bernanke acknowledged that external unforeseen factors contributed to this economic stability.
These elements combined led to lasting shifts in fiscal strategies and risk management that appeared to modulate the prior patterns of boom and bust.
The Subsequent Downfall: The Failure of the Great Moderation
However, the Great Moderation proved to be a double-edged sword. While it created an illusion of stability, it also laid the groundwork for severe consequences later on. The easy monetary policies employed during this period allowed imbalances in the economy to build up. The housing market bubble and subsequent credit crisis around 2008 starkly illustrate this phenomenon.
As Bernanke's optimistic assessment suggested a new era of stability, the underlying vulnerabilities began to surface, culminating in the financial crisis. The collapse of housing prices triggered a swift decrease in consumer wealth, leading to the Great Recession, the worst global downturn since the Great Depression.
The Role of Monetary Policy
During the Great Moderation, the Federal Reserve adopted aggressive monetary policies that included lowering interest rates and increasing the money supply. While these measures temporarily buoyed the economy, they also encouraged risky behavior among financial institutions. The interconnectedness of global markets meant that the repercussions of these policies were not confined within U.S. borders. Ultimately, when the financial markets collapsed, the fallout was worldwide, manifesting in severe economic contractions across the globe.
Lessons Learned from the Great Moderation
The Great Moderation serves as both a cautionary tale and an analytical framework for current economists and policymakers. Below are key takeaways:
-
Fragility of Stability: The ability to engineer stable economic conditions can foster complacency and risk-taking, leading to vulnerabilities that may not be apparent until they materialize catastrophically.
-
understanding Macroeconomic Signals: Policymakers must recognize the importance of identifying economic warning signs and avoid a singular focus on inflation and growth at the expense of financial system health.
-
Global Interdependencies: Economies today are more interconnected than ever, making it imperative for countries to collaborate internationally and learn from shared challenges.
The Great Moderation symbolizes a poignant era of perceived economic stability that ultimately culminated in significant lessons. As economies navigate complex global dynamics today, understanding this historical context remains a vital component in crafting robust and resilient monetary policies.